With Bonds Away, Stocks Try to Play

Banks are closed in the US today in observance of the Veterans Day holiday (Armistice Day in many other countries).  When banks close, so does the bond market^[i].  Yesterday we saw major stock indices plunge after a quiescent morning.  The catalyst appeared to be a poorly received 30-year Treasury auction that caused a spike in long-term yields after 1 PM Eastern time.  It is not surprising that stocks breathed a sigh of relief this morning.  They could make their usual attempt to buy the dip without negative vibes coming from dour bond investors.

At least so far, the attempted rally is fairly muted.  Tech and small stocks, which got hit hardest yesterday, are leading the advance.  Yesterday’s 1.5% drop in the Russell 2000 (RTY) could be explained by the rationale that smaller companies tend to have less pricing power than their larger counterparts.  If inflation is bringing cost pressure, it would depress those companies’ profit margins if they are unable to pass them along to their customers.  It is not clear that those cost pressures have subsided considerably today, but RTY has recouped about half yesterday’s losses this morning.  That index has been a stellar performer over the past month, rising nearly 10% in that time, so it is not unreasonable to see opportunistic buying with index just off record highs.

We have discussed the odd relationship between large tech stocks, best measured by the NASDAQ 100 Index (NDX), and the 10-year Treasury note.  At certain times over the past year, we have seen an inverse trading relationship between NDX and 10-year yields.  The thought is that higher bond yields cause the future cash flows of large cap tech stocks to be discounted more aggressively, dampening the current valuation of the shares.  There is a real logic to that idea, as long as one stipulates that fundamental valuations actually matter to the majority of tech stock investors.  It is not clear that such a tight relationship exists, though.  We saw NDX rise throughout October alongside bond yields, which was also the case during the summer. 

As we see with RTY, NDX is just off record highs after a 10% rally in a month’s time.  Thus, it also makes sense that traders would attempt to buy after yesterday’s dip, especially if the catalyst was a bond market spasm that tech stocks have been able to shrug off at various other points in the past year.

Volatility indices showed some worries yesterday, but not of the sort that displayed any sort of true fear.  We saw VIX jump to nearly 20 as bond prices plunged yesterday, but we finished below 19 – not a sign of panic by any means.  More importantly, at no point did we see anything close to an inversion in VIX futures.  We didn’t even see the curve flatten significantly.  Futures curves tend to invert – meaning short term futures prices exceed longer-term prices – when the commodity in question is in short supply.  There was no shortage of available volatility protection yesterday.  It just cost a little more.  This morning we see VIX back at the 17.5 level that we saw on Tuesday.  Those traders who think that today’s activity is a respite from an inflationary surge are likely to find it an opportune time to purchase protection.

Yesterday morning we asked whether “It remains to be seen whether the collective “meh” reaction by equity investors to the lofty inflation numbers is a sign of underlying strength or collective denial.”  It appears that the latter was the case, at least ahead of the afternoon trading that ensued.  At least for this morning, however, it looks as though some are back to seeking the underlying strength that has been driving equities. 

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[i] That is also the case on Columbus Day in the US.  That said, the stock market closes for Good Friday, which is not a banking holiday,